Are Investors Undervaluing WPP plc (LON:WPP) By 49%?

editorial-team@simplywallst.com (Simply Wall St)

Sun, Dec 31, 2023, 10:08 PM 6 min read

Today we will run through one way of estimating the intrinsic value of WPP plc (LON:WPP) by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for WPP

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£1.11b	UK£1.24b	UK£1.20b	UK£1.25b	UK£1.26b	UK£1.28b	UK£1.29b	UK£1.31b	UK£1.33b	UK£1.35b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x2	Analyst x1	Analyst x1	Est @ 1.12%	Est @ 1.24%	Est @ 1.32%	Est @ 1.38%	Est @ 1.42%
Present Value (£, Millions) Discounted @ 8.9%	UK£1.0k	UK£1.0k	UK£930	UK£885	UK£823	UK£764	UK£711	UK£661	UK£615	UK£573

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£8.0b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£1.3b× (1 + 1.5%) ÷ (8.9%– 1.5%) = UK£18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£18b÷ ( 1 + 8.9%)¹⁰= UK£7.9b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£16b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£7.5, the company appears quite undervalued at a 49% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf — LSE:WPP Discounted Cash Flow January 1st 2024

The Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at WPP as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.9%, which is based on a levered beta of 1.251. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for WPP

Strength

Debt is well covered by earnings and cashflows.

Dividends are covered by earnings and cash flows.

Weakness

Earnings declined over the past year.

Dividend is low compared to the top 25% of dividend payers in the Media market.

Opportunity

Annual earnings are forecast to grow faster than the British market.

Good value based on P/E ratio and estimated fair value.

Threat

Annual revenue is expected to decline over the next 4 years.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For WPP, we've compiled three pertinent items you should consider:

Risks: Case in point, we've spotted 2 warning signs for WPP you should be aware of.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for WPP's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.